The Off-Balance Sheet Liability: Why Integrity Is An Important Investment Filter

Buffett, West Point, and the high cost of managerial hypocrisy

When I was 11 years old, my family moved to Northern New Jersey from Cincinnati. Some of my fondest memories from those years are the day trips we’d take to the U.S. Military Academy at West Point, particularly in the autumn when the Hudson River Valley is bursting with warm yellows, oranges, and reds.

On one of those trips to West Point, we walked around a campus chapel and my dad picked up a copy of the “Cadet Prayer.” We both liked it so much that we held onto the copy for many years. It’s still likely tucked away somewhere.

Photo by Dave Lowe on Unsplash

The prayer, written in 1920, is meant for West Point cadets training to be U.S. Army officers. Its central theme is integrity.

Here’s my favorite section:

Strengthen and increase our admiration for honest dealing and clean thinking, and suffer not our hatred of hypocrisy and pretence [sic] ever to diminish. Encourage us in our endeavor to live above the common level of life. Make us to choose the harder right instead of the easier wrong, and never to be content with a half truth when the whole can be won.

As the writer understood, effective leadership demands uncompromising integrity. If a leader is corrupt or hypocritical - even in seemingly trivial matters - their example reverberates through the unit or organization, ultimately eroding trust and undermining the organization’s mission.

During his final Berkshire Hathaway annual meeting, Warren Buffett echoed these sentiments.

A manager that behaves differently than what he’s asking the people beneath them to behave – it just doesn’t work over time.

And people want a manager that they admire and they’re not going to admire them if those people profess to behave in one manner and behave in another manner. It’s easier – this is a sad thing, but it’s easier for an organization to see its quality move downward than it is upward.

I mean, if the boss behaves badly, it causes everybody to behave badly. That is really catching. It’s not as catching on the way up in upper management. But if the manager is doing a lot of little things to grease his own situation, pretty soon, let’s say you’re running a retail establishment, pretty soon all the employees or a lot of the employees are telling their friends that they get a discount with the retail operation and if they want something they’ll put it on their account and then get the discount.

Once you start deviating downward, it is really contagious and it is hard to rebuild. So, you really need someone that behaves well on top and is not playing games for their own benefit.

Having decades of experience working with hundreds of managers, Buffett understands the off-balance sheet liability and the downward cultural inertia created when a company is led by managers with low integrity.

As an outside investor, it can be difficult to size up the integrity of the management teams we own, but it’s important to remain vigilant in this endeavor - both before and during the investment.

Here’s a quick example. In a previous role, we invested in a promising small cap led by an impressive founder/CEO. Publicly, the CEO said he was focused on the company’s fundamental growth and didn’t pay attention to the market price of the company’s stock.

In one interaction with the CEO, however, I discovered that what he was saying publicly was not how he was operating privately. I learned that the motivation for making a particular capital allocation decision, which I did not believe was in shareholder interests, was to prove the short-sellers wrong (he used more colorful language). Under pressure from short sellers, it became clear that the daily stock price mattered more than he was letting on.

Measuring public statements versus private behavior is one way to evaluate management integrity. Here are a few more to consider:

• Transparent communication

  • Is management frank when answering tough questions on conference calls and in shareholder letters? Do they address the company’s weaknesses or bury them under corporate word salad?

• Consistent disclosures

  • I’m skeptical of companies that regularly change their segment reporting structures. This makes it difficult for investors to hold management accountable for poor results and it’s a sign that the culture is to cover up blemishes rather than take responsibility for them.

• Actions taken while under pressure

  • How did the company respond during the COVID pandemic or near the bottom of its most recent industry cycle? Were they fanatic about “making the quarter” by any means or did they remain focused on the long-term plan? Would you have been proud to work for them during that period?

• Financial alignment

  • As Charlie Munger famously said, “Show me the incentive, and I’ll show you the outcome.” Look through the company’s proxy statements over time. Have the bonus metrics changed to make sure management gets its bonuses? Has there been a time when management failed to get a full bonus or does the board always find a way to make sure management gets a full bonus?

• Treatment of stakeholders

  • Forbes magazine founder, Malcolm Forbes, once said, “You can easily judge the character of a man by how he treats those who can do nothing for him.” While a company may get some benefit from each of its stakeholders, some have a more direct impact on results than others. Pay attention to the company’s reputation among its suppliers, in its community, and with its employees.

• Governance

  • Take a closer look at the company’s board of directors and its structure. Are there enough independent board members? Do the board members have relevant experience? How much are they paid versus close peers? Ultimately, you want to understand the degree to which the board will hold management accountable. At the very least, you want to avoid situations where the board is stacked with “yes” people who are unable or unwilling to challenge the executives.

One of the perks of operating in the public markets is that you don’t need to tolerate hypocrisy or warning signs about a management team’s integrity. With a few clicks, you can sell and find a better place for your capital.

A management team or CEO lacking integrity doesn’t necessarily mean the company is doomed to failure, but there’s increased risk of unexpected value destruction. If you decide to look the other way when you spot an obvious lack of integrity, you shift from investor to gambler. If the speculation doesn’t pay off, you only have yourself to blame.

Negative surprises are always possible with any company. Management teams are full of neither saints nor crooks. Nuance is an important consideration, but it’s important to establish your own code for what you're willing to tolerate and what you aren’t.

You can’t screen for integrity. It’s a qualitative analysis that relies on your ability to spot hypocrisy, pretense, easier wrongs, and half truths. Ancient wisdom to the present suggest that this is an important skill to hone in life, business, and investing.

How do you think about evaluating integrity? Please let me know in the comments below.

Stay patient, stay focused.

Todd

---

More on this topic:

Too Many Professional Managers, Not Enough Stewards

Economic Moats Explained: What They Are & Why They Matter - Part VI

---

Todd Wenning is the founder of KNA Capital Management, LLC, an Ohio-registered investment advisor that manages a concentrated equity strategy and provides other investment-related services.

At the time of publication, Todd, his immediate family, and/or KNA Capital Management, LLC or its clients own shares of Berkshire Hathaway.

Please see important disclaimers.